Economics and Stock Market31 Dec 2011 02:35 pm

Everyone Loses: Stock Market 101

Since the 1970’s the percent of people and stock trade activity which is involved in mutual funds and index funds in particular has mushroomed. While the frequent day traders have become more active, the typical non-professional as well as professional trader still engages in the buy and hold strategy advocated by market experts since there has been a stock market.

The goal of this post is to point out that the buying and holding of index funds in particular is seldom a winning proposition and very likely a sure way of slowly losing almost all your assets. Let me use this year as an example. I will attempt to use enough math examples to prove my point without traumatizing or boring those who are math-o-phobic.

Any fund that adjusts itself on a daily basis is almost inevitably going to lose value over time. This is true of all index funds and to my knowledge a great deal of mutual funds that deal with the bundling of several stocks.

Okay this is how it works (or doesn’t work for the investor). For convenience sake I’ll use nice round figures.

Let’s say that I have $100,000 invested long in the Nasdaq 100 (top 100 technology companies). Long means the standard way of trading in which I’m hoping for the market to go up. On my first day the Nasdaq rises from 2000 to 2060 an advance of 3%. To make the numbers big enough to quickly show what happens let’s say that I owned a fund such as RYVYX an ETF which doubles the movement.

So, in effect the market went up 6% and after one day I made a quite impressive $6000. Let’s say the next day the market gave back all it had gained and the Nasdaq returned to 2000. The drop from 2060 to 2000 comes out to a 2.9% drop. So, while yesterdays gain was 3% a drop of only 2.9% gets us back to even. Yet, while this sounds like you actually would have made a little money or stayed the same the actual math will show that you surprisingly lost some money.

Since you started the day at 106,000 you lost 5.8% of 106,000 which you get by multiplying .942 of 106,000 which comes out to 99,852. So during your two day round trip you actually lost $148.

Rather than give you a host of mathematical examples let’s take a look at what happened this year. The Nasdaq 100 began the year at 2218 and ended the year at 2278. This means that the Nasdaq 100 went relatively nowhere this year and if you owned an ETF or mutual fund on this index you would expect a modest gain of 2.7%.

In the example above I used a fund which doubled the movement of the index. Well if you wanted the maximum amount of potential gain you can own funds which triple the move of the index such as TQQQ for the Nasdaq 100. In owning the TQQQ then you would anticipate a gain of near 8.1% for the year (2.7 x 3). Yet, the actual performance of this ETF is quite different.

TQQQ ended last year at $73.94 and closed yesterday at $67.99. Therefore instead of gaining the expected 8.1% the fund logically would produce by its tracking the Nasdaq 100 it actually lost a hair over 8%. This means that due to how the index fund tracks the fund on a daily basis that the markets ups and downs caused the fund to deviate significantly to the downside.

In essence if you started the year with $100,000 you would currently have about $92,000. So while the market went up and you should have gained over 8%, you actually lost $8,000.

Now, as many of you know you can buy index funds which “short” the market. So, instead of you making money when the market goes up, you make money when the market goes down. The ETF SQQQ is the short version of the TQQQ which means that it should do the exact opposite.

If you owned the SQQQ for the entire year you would expect that since the market went down 2.7% that you would have lost 8.1% for the year. So, your $100,000 would be right near $92,000.

Well, let’s look at the actual numbers for SQQQ. The SQQQ ended last year at $31.18 and ended this year at $19.69. Okay, so $19.69 is only 63% of of $31.18. So instead of losing an expected 8% you would have in fact lost 37% of your money. Your $100,000 would have shrunk down to $63,000.

Okay, to review, despite the fact that the market went up a mere 2.7% for the year you would have lost money through the buying and holding of index funds whether you played the market to go up or down. These popular index funds were a lose/lose proposition.

Many studies suggest that over 80% of investors lose money. These studies fly in the face of market “experts” who claim that statistics show that despite setbacks even dramatic ones, that those long term investors who patiently buy and hold will typically find their money double every 8 to 10 years.

As you can see from the above example, which is more common than uncommon, the long term buy and hold approach may not be a wise one for most investors.

There are probably those out there who may object that the above example does not include the “dollar cost averaging” strategy of “experts” who advocate investing money into stocks at set intervals. The logic behind this is that pouring money into stocks when they are cheap (stock market has gone down) will just give you more shares and have your money earn more as the market recovers.

I became suspicious of this tendency for everyone to lose in the long term holding of index funds a few years ago. And over the past year ago I’ve factored in the use of “dollar cost averaging” on a monthly and quarterly basis without seeing any significant benefit to ending or even easing the steady erosion of wealth of index investing.

I’m not saying that successful index investing is impossible. I’m only pointing out that the practical and mathematical reality of this style of investment is rife with obstacles and complications, and that investor caution is more than warranted.

Jim Guido

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